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Buying And Selling Bankruptcy Proofs Of Claim: Understanding The Risks

Attorneys who deal with Chapter 13 and Chapter 11 cases will often see, in the claims registers listing the filed proofs of claim, corporate entities that have “bought up” proofs of claim from smaller creditors. There are many companies, businesses, distressed debt investors, and hedge funds that specialize in purchasing bankruptcy debt. There are also situations where larger creditors in Chapter 11 cases will make offers to buy the claims of smaller creditors, in an attempt to control the voting and direction of the Chapter 11 case. Small creditors in bankruptcy cases may find themselves in confusion about what to do if they are contacted by a large organization asking to buy their claim.

What issues should be considered? What are the advantages and disadvantages of selling a proof of claim?

Claims buyers can scrutinize bankruptcy court records and comb cases to see if it makes economic sense for them to purchase claims. Claims buyers will prefer to purchase claims that are listed as “undisputed” rather than “contingent” or “disputed”, since undisputed debts are less likely to subject to litigation in a bankruptcy case. They are seen as less of a risk.

Claims buyers will frequently sent out documents called “claim assignment agreements” or “confirmation” documents. These documents should be reviewed carefully with an attorney with bankruptcy experience, before the claim is sold. Things are not often what they appear. Claims buyers have as their goal the maximization of their profit with a minimization of their risk. With this in mind, let us examine the pros and cons of selling a bankruptcy proof of claim.

Pros

One of the most attractive reasons for selling a claim is the prospect of cash now, rather than the uncertainty of knowing when (if ever) the creditor will recover any funds in the bankruptcy estate. Cash now has a real attraction to many small creditors who may not want to participate in the bankruptcy process. Small creditors are enticed with the prospect of immediate liquidity, rather than dealing with the possibility of drawn-out legal proceedings. Selling a claim now carries with it the perception of cutting one’s losses and eliminating future risk. This “immediacy” value is the primary attraction of selling a claim.

Cons

But this immediate liquidity can be deceptive. For one thing, it is important to remember that claims buys always want to buy at a steep discount. It is a numbers game to them, and they buy claims in volume. The amount you may be offered for your claim will be a fraction of what it may be worth. Bankruptcy cases can be unpredictable. Many cases that initially appear to offer nothing to unsecured creditors can generate significant funds down the road. You never know when assets can and will be recovered. To sell your claim too early can be a mistake.

Claims buyers often put crafty language into their “claim assignment agreements” that shift their risks back on to you, the seller. Some of these provisions are buried in the fine print of the agreements. Sometimes, language will be inserted that give the buyer the option of dumping the claim back on you (the seller) if an objection is filed to the proof of claim, even if the objection is later defeated. Basically, the claims buyer can often use the fact of a claim challenge (by a bankruptcy debtor) to get its money back from a claims seller. Objections to claims, preference actions, and other things that create work for a claims buyer can be used as a way of bailing out of their agreement with a claims seller. Remember, the claims buyer is interested in making money with as little effort as possible. Their goal is not to litigate claims in bankruptcy court. Faced with a challenge, they will move on.

Another tactic used by claims buyers is to insert language in their agreements to require you (the seller) to defend the claim against possible objections at your own expense, and to pay the claims buyer back for any portion of the claim that might be disallowed. The bottom line is this: even after selling your claim, there is a possibility that you could incur costs in a bankruptcy case.

Your setoff rights may also be limited in a claim assignment agreement. Some provisions of these agreements contain provisions limiting your rights to assert a setoff or recoupment against the bankruptcy debtor, or requiring you to pay back some (or all) of the purchase price if you do assert a setoff .

Unsecured creditors who may be serving on a creditors’ committee in a Chapter 11 case may have limitations on their rights to sell claims. In some circumstances, there are confidentiality or other issues that will prevent such sales. It is important to get legal advice in this type of situation. Bankruptcy courts also sometimes restrict the rights of creditors from selling their claims. Such rules are intended to prevent large institutional creditors from buying up claims and controlling the voting dynamics in Chapter 11 cases. Another reason is to preserve the tax benefits of a debtor’s net operating losses (NOL), which can be lost if ownership of large amounts of claims changes.

When a claim is sold, a document called a “evidence of transfer of claim” is produced which is filed with the bankruptcy court. As a safeguard against fraud, when such a document is filed, the seller is given an short opportunity to object to the transfer, just in case the transfer was fraudulent.

Buying debt in bankruptcy cases, for large claims buyers, is all about making a profit. Their goal will be to maximize their profit potential, while minimizing their risk. Small creditors in bankruptcy cases should be aware of this. The enticement of immediate money may be an illusion. A small creditor who ignores the risks may find that he got more than he bargained for. It is critical to consult with a bankruptcy attorney before selling your claim, so that you are aware of all the risks involved.

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